"I need 25% margin to be
profitable" you say. "So why don't you price to achieve that margin?" I
ask. "Your 25% mark-up is actually a 20% margin!" It usually takes half
an hour plus a calculator and several scraps of paper before they agree
that they are pricing their product/service 5% lower than they intended.

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Almost
every contractor I worked with over the last few years, and there have
been many, used a mark-up formula in their pricing. In most cases it
was something like $55 per hour for labor, plus materials marked up
25%. (We will talk about the labor charge later because it is more
complicated)

“I
need 25% margin to be profitable” they say. “So why
don’t you price to achieve that margin?” I ask. “Your
25% mark-up is actually a 20% margin!” It usually takes half an
hour plus a calculator and several scraps of paper before they agree
that they are pricing their product/service 5% lower than they
intended.

You can try it
yourself, remembering that the formula for margin is:

Gross Margin
% = (Selling Price – Cost)/Selling
Price all *100.

but to
save a little time, here is a table:

Mark-up %
Mark-up
Factor
Margin %

10.00%
1.10
9.09%

15.00%
1.15
13.04%

20.00%
1.20
16.66%

25.00%
1.25
20.00%

33.33%
1.33
25.00%

40.00%
1.40
28.57%

50.00%
1.50
33.33%

As you can
see, the margin mark-up disparity increases as the mark-up increases.
So remember, to get your 25% margin, you need to mark-up by 33.33%. By
doing that you increase you profit by 5%. For the mathematically minded,
it is interesting to rework the formula for gross margin in terms of
mark up factor, and you get:

Gross Margin %
= Markup %/Markup Factor.

This rework clearly shows
that the resulting gross margin percent must always be less than the
markup %..

OK, so what is
the point? The point is that the difference can turn a profit into a
loss. Let us assume your overheads are running at 25% of sales. If you
want to make a profit of 5% on sales you must have a margin of 30%.
That is a mathematical requirement. If you interpret this to mean a
markup of 30% your margin is only 23%, so instead of making 5% profit
you are losing 2%.

When you read this it all seems so obvious, but think seriously about
the implications. In the example used above, the difference between
using a margin of 30% and a mark-up of 30% is 7%, and that 7% is out of
your pocket. The numbers I use in the example are taken from an actual
client. He worked his heart out for years, keeping his head above water
by taking a low salary and working long hours (Sound familiar!). A
little training in the management skills required to be a small
business CEO gave him his life back.

(Just for interest, some
of you may want a formula for finding the markup factor for a
specific gross margin. That is quite simple - it is:

Mark up factor = 1/Gross Margin
% all *100.)

In a later article we will talk about the labor element, but suffice to
say here, that is one of the most incorrectly calculated elements of
pricing by a majority of contractors.

The Author
After 25 years consulting to small and medium sized companies,
Mike Anderson, principal of Train Me To Be a CEO
realized that the most important part of his work was training the CEO,
and the reason he was such a good consultant was that he did that very
well.

Trained as an engineer, he became a CEO of
a midsize corporation at the age of 35. After a spell at Harvard
Business School he entered the world of consulting.

3. Ongoing mentorship. Begins with a minimum two
day one on one, but continues with monthly or quarterly follow up
sessions. (Smart and probably Best!) .

References

A New England Contractor

"Mike Anderson has been working diligently
with the upper management team at (our firm). Mike is extremely
knowledgeable and has an exceptional way of dealing with many different
personalities. He has worked very closely with the Sales Team to
impress upon them the importance of using a consistent method of
estimating. He was instrumental in restructuring our accounting
procedures."